Use bonds to finance commitments as well as returns

Learning goals

• Compare income, liability and total-return fixed-income mandates.
• Integrate liquidity, leverage, taxation and ladder design.

Draft · approximately 60 minutes, excluding further revision.

Decision case · fictional facts

A fictional plan has liabilities PV 100 million with modified duration 6 and bond assets 110 million with duration 5. Its bond return assumptions are carry 4%, roll-down 0.5% and a parallel yield rise 0.2 percentage points. Some benefits are paid annually for five years; the committee considers a maturity ladder, leverage and exact cash-flow matching.

Define the role and decomposition

Bonds can provide income, diversification, liquidity or liability matching, but credit, inflation, rate and currency risks differ by sector. Horizon return can be decomposed into income, roll-down, rate/spread price changes, defaults and reinvestment. Duration and convexity summarize some price sensitivity; spread duration and key-rate measures refine exposures. Correlation with equities can change across regimes.

Liquidity differs among sovereign, corporate, securitized and smaller issues; quoted prices may not be executable at size. Leverage via borrowing, repo or derivatives can increase exposure and create collateral/margin needs. Model funding, haircuts and forced-sale scenarios, not only extra yield.

Match the obligation and after-tax investor

Cash-flow matching dedicates payments to dated liabilities but can be costly, imperfect under default or optionality and restrictive in the available universe. Immunization matches value and appropriate rate sensitivities with rebalancing; matching duration alone is insufficient when values differ. A ladder spreads maturities to balance reinvestment and price risk, but does not exactly match every liability or remove credit loss.

Taxable and tax-exempt investors can rank instruments differently after tax and realization timing. Use current applicable rules rather than assuming a nominally tax-favored asset is always better. Compare liability currency, inflation and horizon as well as yield.

Bond liquidity, returns and leveraged funding

Bond liquidity depends on issue size, dealer capacity, age, concentration and market conditions. A large sovereign issue may be easier to trade than a bespoke securitization, but even benchmarks can gap in stress. Compare executable depth and implementation cost, not only quoted midprices. Spread and key-rate duration, convexity and credit exposures complement total volatility; bond/equity correlation can reverse across inflation regimes.

Return decomposition includes income, roll-down, curve/spread repricing, credit loss and reinvestment under a stated horizon. Borrowing or repo can lever these returns but haircuts, funding maturity and margin demands can force liquidation before a thesis works. For assets10 funded with equity2 and borrowing8, a5% asset loss consumes0.5, or25% of equity before interest. Leverage changes funding resilience as well as volatility.

After-tax liability matching and ladder design

A taxable investor compares after-tax income and realization timing, while a tax-exempt investor need not sacrifice yield for a tax preference it cannot use. For hypothetical20% tax on all interest, a5% taxable yield nets4%; compare an otherwise identical exempt3.5% only after checking credit, maturity and applicable rules. This assumed rate is not jurisdiction-specific advice.

Liability-driven portfolios match the currency, inflation and date of obligations as well as interest sensitivity. Cash-flow matching dedicates payments to dates; immunization uses value and sensitivity with monitoring. A ladder spreads maturities to balance reinvestment and price risk but cannot guarantee every dated benefit payment, and default/embedded options can break matching. Assess transaction and rebalancing costs and retain liquidity for imperfect matches.

Formula and assumptions

Dollar duration=PV×modified duration; horizon return≈carry+roll−D×Δy

Errors to catch

• Using asset duration without liability values.
• Calling a ladder an exact guarantee of all payments.

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• Reference · www.cfainstitute.org